1. McGraw-Hill/Irwin Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 4 Mutual Funds and Other Investment Companies

2. 4-2 Investment Companies Investment Company Act of 1940 which classifies into: Unit trusts – portfolio fixed for life of fund (unmanaged) Managed Investment Companies Closed End Open End – “Mutual Funds” About 90% of investment company assets are here.

3. 4-3 Other Investment Organizations Commingled Funds – partnerships that pool funds (e.g. trust or retirement accounts pool into a common fund). Are like large investor open ended funds REIT (Real Estate Investment Trusts) – similar to closed end funds, but established by separate legislation and must invest passively in real estate Hedge Funds – not registered and not subject to SEC regulation. Used by “sophisticated” investors and financial intermediaries. Often use high leverage

4. 4-4 Mutual Funds Our goal in this chapter is to understand the different types of mutual funds, their risks, and their returns. Around 1980, 5 million Americans owned mutual funds. However, by 2001, 93 million Americans in 55 million households owned mutual funds. In 2001 investors added $505 billion in net new funds to mutual funds. In 2001, mutual fund assets totaled $7 trillion. In 2002, mutual fund assets totaled 6.4 trillion.

5. 4-5 Mutual Funds Mutual funds are simply a means of combining or pooling the funds of a large group of investors. The buy and sell decisions for the resulting pool are then made by a fund manager, who is compensated for the service provided. Like commercial banks and life insurance companies, mutual funds are a form of financial intermediary.

6. 4-6 Mutual Fund Operations: Organization and Creation A mutual fund is simply a corporation. It is owned by shareholders, who elect a board of directors. Most mutual funds are created by investment advisory firms (say Fidelity Investments), or brokerage firms with investment advisory operations (say Merrill Lynch). Investment advisory firms earn fees for managing mutual funds.

7. 4-7 Taxation of Investment Companies A “regulated investment company” does not have to pay taxes on its investment income. To qualify, an investment company must: Hold almost all its assets as investments in stocks, bonds, and other securities, Use no more than 5% of its assets when acquiring a particular security, and Pass through all realized investment income to fund shareholders

8. 4-8 The Fund Prospectus and Annual Report Mutual funds are required by law to supply a prospectus to any investor who wishes to purchase shares. Mutual funds must also provide an annual report to their shareholders.

9. 4-9 Administration & record keeping Diversification & divisibility Professional management Reduced transaction costs (economies of scale in trading) Services of Investment Companies

10. 4-10 Investment Companies and Fund Types An Investment company is business that specializes in pooling funds from individual investors and making investments. An Open-end fund is an investment company that stands ready to buy and sell shares in itself to investors, at any time. A Closed-end fund is an investment company with a fixed number of shares that are bought and sold by investors, only in the open market.

11. 4-11 Shares Outstanding Closed-end: no change unless new stock is offered. Open-end: changes when new shares are sold or old shares are redeemed. Pricing Open-end: Net Asset Value(NAV) Closed-end: Premium or discount to NAV Open-End and Closed- End Funds: Key Differences

12. 4-12 Used as a basis for valuation of investment company shares. Selling new shares Redeeming existing shares Calculation Market Value of Assets - Liabilities Shares Outstanding Net Asset Value

13. 4-13 Mutual Fund Costs and Fees Sales charges or “loads” Front-end loads are charges levied on purchases. Back-end loads are charges levied on redemptions. 12b-1 fees. SEC Rule 12b-1 allows funds to spend up to 1% of fund assets annually to cover distribution and marketing costs. Management fees: Usually range from 0.25% to 1.00% of the funds total assets each year. Are usually based on fund size and/or performance.

14. 4-14 Mutual Fund Costs and Fees Trading costs Not reported directly Funds must report "turnover," which is related to the amount of trading. ((Avg Assets)/Sales) The higher the turnover, the more trading has occurred in the fund which increases costs. Turnover also creates capital gains for investors Mutual Funds may be “reimbursed” for order flow (increases trading costs, but is not a fee that is reported). So called “soft dollars” Benefit – a large trader like a mutual fund can get good allocation of IPO’s

15. 4-15 Expense Reporting Mutual funds are required to report expenses in a fairly standardized way in their prospectus. Shareholder transaction expenses - loads and deferred sales charges. Fund operating expenses - management and 12b-1 fees, legal, accounting, and reporting costs, director fees. Must provide hypothetical example showing the total expenses paid by investors through time per $10,000 invested.

16. 4-16 Example: Fee Table

17. 4-17 Example: Fee Table

18. 4-18 Why Pay Loads and Fees? After all, many good no-load funds exist. Don’t know any better? Or, You may want a fund run by a particular manager. All such funds are load funds. Or, you may want a specialized type of fund. Perhaps one that specialized in Italian companies Loads and fees for specialized funds tend to be higher, because there is little competition among them.

19. 4-19 Investment Companies and Fund Types

20. 4-20 Short-Term Funds, I. Short-term funds are collectively known as money market mutual funds. They hold money market instruments Money market mutual funds (MMMFs) are mutual funds specializing in money market instruments. MMMFs maintain a $1.00 net asset value to make them resemble bank accounts. Depending on the type of securities purchased, MMMFs can be either taxable or tax-exempt. Often allow “check writing”

21. 4-21 Short-Term Funds, II. Most banks offer what are called “money market” deposit accounts, or MMDAs, which are much like MMMFs. The distinction is that a bank money market account is a bank deposit and offers FDIC protection.

22. 4-22 Long-Term Funds There are many different types of long- term funds, i.e., funds that invest in long- term securities. Historically, mutual funds were classified as stock funds, bond funds, or income funds. Nowadays, the investment objective of the fund is the major determinant of the fund type.

23. 4-23 Stock Funds, I. Some stock funds trade off capital appreciation and dividend income. Capital appreciation Growth Growth and Income Equity income Some stock funds focus on companies in a particular size range. Small company Mid-cap Some stock fund invest internationally. Global International Region Country Emerging markets

24. 4-24 Stock Funds, II. Sector funds specialize in specific sectors of the economy, such as: Biotechnology Internet Energy Other fund types include: Index funds Social conscience, or “green,” funds “Sin” funds (i.e., tobacco, liquor, gaming) Tax-managed funds

25. 4-25 Index Funds Pioneered by Vanguard. Its “Index Trust 500”, based on the S&P 500 is the largest mutual fund in the world (Inception: August 31, 1976) Very low costs – typically 20 bp or less for S&P 500 based funds. Higher for specialty indexes and international Low turnover (5% annually, versus 85% for the average managed stock fund) Tax efficient – it is typically near the top 20% of funds on an after tax basis

26. 4-26 From Vanguard.com Statistical snapshots 71% of Vanguard index funds outperformed their respective peer-group averages over the ten years ended March 31, 2006. When Vanguard 500 Index Fund began operations in 1976, it was one of 360 U.S. stock funds; 149 of these no longer exist. 2005 expense ratios for funds tracking the S&P 500 Index: Industry average: 0.59%; Vanguard 500 Index Fund: 0.09% (Admiral™ Shares) and 0.18% (Investor Shares).Source of industry data: Lipper Inc.

27. 4-27 Bond Funds Bond funds may be distinguished by their Maturity range Credit quality Taxability Bond type Issuing country Bond fund types include: Short-term and intermediate-term funds General funds High-yield funds Mortgage funds World funds Insured funds Single-state municipal funds

28. 4-28 Stock and Bond Funds Funds that do not invest exclusively in either stocks or bonds are often called “blended” or “hybrid” funds. Examples include: Balanced funds Asset allocation funds Convertible funds Income funds

29. 4-29 Mutual Fund Objectives: A mutual fund “style” box is a way of visually representing a fund’s investment focus by placing the fund into one of nine boxes: GrowthBlendValue Large Medium Small Size Style

30. 4-30 Mutual Fund Objectives: In recent years, there has been a trend toward classifying a mutual fund’s objective based on its actual holdings. For example, the Wall Street Journal classifies most general purpose funds based on the market “cap” of the stocks they hold, and also on whether the fund tends to invest in “growth” or “value” stocks (or both).

31. 4-31 Mutual Fund Objectives

32. 4-32 Mutual Fund Performance Mutual fund performance is very closely tracked by a number of organizations. Financial publications of all types periodically provide mutual fund data. The Wall Street Journal is particularly timely print source. www.morningstar.comwww.morningstar.com has a “Fund Selector” that provides performance information

33. 4-33 Mutual Fund Performance

34. 4-34 Mutual Fund Performance

35. 4-35 A First Look at Fund Performance Benchmark: Wilshire 5000 Results Most funds underperform Not fair comparison because of costs Adjusted Benchmark: Wilshire 5000 with passive management costs considered. The majority of funds still under-perform.

36. 4-36 Consistency of Fund Performance Do some mutual funds consistently outperform? Evidence suggests that some funds show consistent stronger performance. Depends on measurement interval Depends on time period Evidence shows consistent poor performance.

37. 4-37 Mutual Fund Performance While looking at historical returns, the riskiness of the various fund categories should also be considered. Whether historical performance is useful in predicting future performance is a subject of ongoing debate. Some of the poorest-performing funds are those with very high costs.

38. 4-38 Closed-End Fund Performance A closed-end fund has a fixed number of shares. These shares are traded on stock exchanges. There are about 450 closed-end funds that have their shares listed on U.S. Stock Exchanges. There are about 7,000 long-term open-end mutual funds.

39. 4-39 Mutual Fund Performance

40. 4-40 The Closed-End Funds Discount Most closed-end funds sell at a discount relative to their net asset values. The discount is sometimes substantial. The typical discount fluctuates over time. Despite a great deal of academic research, the closed-end fund discount phenomenon remains largely unexplained.

41. 4-41 Exchange Traded Funds An exchange traded fund, or ETF, Is basically an index fund. Trades like a closed-end fund (without the discount phenomenon). They are heavily traded. An area where ETFs seem to have an edge over the more traditional index funds is the more specialized indexes. A well-known ETF is the “Standard and Poor’s Depositary Receipt” or SPDR. This ETF mimics the S&P 500 index. It is commonly called “spider." A list of ETFs can be found at www.amex.com.www.amex.com

42. 4-42 Hedge Funds Like mutual funds, hedge funds collect pools of money from investors. However, Hedge funds are not required to register with the SEC. Hedge funds are not required to maintain any particular degree of diversification or liquidity. Are often highly levered. Hedge fund investors must qualify as “financially sophisticated” investors. Hedge fund managers have considerable freedom to follow various investment strategies, or styles. Hedge fund fees: General management fee of 1-2% of fund assets Performance fee of 20-40% of profits

43. 4-43 Useful Internet Sites www.ici.orgwww.ici.org (reference for mutual fund facts and figures) www.vanguard.comwww.vanguard.com (example of major fund family website) www.fidelity.comwww.fidelity.com (website of largest investment advisory firm in US) www.ipsfunds.comwww.ipsfunds.com (reference for “plain language” risk disclosure) www.mfea.comwww.mfea.com (reference for info on thousands of funds) www.morningstar.orgwww.morningstar.org (reference for one of the best mutual fund sites) www.vicefund.comwww.vicefund.com (reference for “vice” funds) www.socialinvest.orgwww.socialinvest.org (reference for “social conscience” funds) www.hedgefundworld.comwww.hedgefundworld.com (reference for hedge fund information) www.turnkeyhedgefunds.comwww.turnkeyhedgefunds.com (reference to start your own hedge fund)

44. 4-44 Review: Mutual Funds Investment Companies and Fund Types Open-End versus Closed-End Funds Net Asset Value Mutual Fund Operations Mutual Fund Organization and Creation Taxation of Investment Companies The Fund Prospectus and Annual Report Mutual Fund Costs and Fees Types of Expenses and Fees Expense Reporting Why Pay Loads and Fees? Short-Term Funds Money Market Mutual Funds Money Market Deposit Accounts

45. 4-45 Review: Mutual Funds Long-Term Funds Stock Funds Taxable and Municipal Bond Funds Stock and Bond Funds Mutual Fund Objectives: Recent Developments Mutual Fund Performance Mutual Fund Performance Information How Useful are Fund Performance Ratings? Closed-End Funds and Exchange Traded Funds Closed-End Funds Performance Information The Closed-End Fund Discount Mystery Exchange Traded Funds